The cover story of a recent issue of Bloomberg Businessweek, “Everything is Private Equity Now,” caught my eye. I do see some truth in this seemingly exaggerated title. Over the last 10 years, I have witnessed most large private foundations I work with either venturing into private equity or gradually increasing their asset allocation to private equity.

This article turned out to be a very informative read. It explains how private equity works, and it further explores its impact on the economy and various industries as well as its social and political influences. What resonated with me the most is the part titled “The returns are spectacular. But there are catches.”

The Stats

It stated that over the last 25 years, private equity funds returned more than 13 percent annualized, compared to nine percent in the S&P 500. However, hidden in these “spectacular returns” are three main “catches:”

  1. The value of private investments is hard to measure
  2. Returns can be gamed
  3. Returns have deteriorated over the last two decades

I cannot help reflecting on these in relation to the private equity investments I have encountered in many private foundation audits and the unique challenges they present. First, since one cannot look up the market value of a given private equity investment on a stock exchange, foundation management relies on the private equity manager for the investment’s fair market value. Most private equity managers provide fair market value only on a quarterly basis and often with a 30-day or more time lag from the quarter-ends.

Furthermore, the fair market value on these quarterly statements marked as “preliminary” or “unaudited” could turn out to be different later on, once the private equity fund undergoes its own annual audit.

Lastly, for those inquisitive enough to read the fund’s audited financial statements, one will most likely find out that the fund’s underlying investments in privately held companies are “level 3” in the fair value hierarchy. By Financial Accounting Standards Board definition, a “level 3” valuation is based on unobservable inputs where there is little, if any market activities. They are essentially estimates by the private equity manage – verified by their auditor. Or as the Businessweek article puts it, they are “hard to measure” and “can be gamed.”

Do Your Due Diligence

To sum up, from an investor’s auditor’s perspective, I would emphasize that due diligence prior to making any investment is essential but more so with private equity investments. The reputations of the private equity manager as well as the fund’s auditor are both important. After all, these are the two parties the investor has to rely on for the valuation of their investments. In addition, for private foundations specifically, speculative investments are prohibited by the IRS regulations. The board and management of private foundations have a fiduciary responsibility to ensure that carrying out the exempt purpose of the organization is not jeopardized. An excise tax is levied on jeopardizing investments as defined by the IRS. Therefore, sufficient documentation of the aforementioned due diligence is also highly recommended.

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Stephanie Yan

Stephanie Yan, CPA, has more than 20 years of public accounting experience providing audit, accounting and general business consulting services. Before coming to GHJ in 2004, Stephanie spent three years working in corporate accounting for both privately held and public companies. Her industry…Learn More